In fact, there are four segments for the responsibility centers, which are cost center, revenue center, investment center and profit center. The manager of these segments will be having the greatest influence over the key elements to be managed. Decentralization will be taken within the management so that the there is the manager or individual can have the right to make decision on the allocation of resources for the activities. For example, due to the increasing demand in the market, the production manager set a target on increase 10% of the production within 3 months. He decided to hire more worker and extent the manufacturing period for two more hours. Therefore, the expenses on the salary, electricity and rental fees will be traced to the cost center as production department is under it. The advantages and disadvantages of the application of responsibility accounting are as the following:
Advantages:
- Better way to manage the large diversified organization
- Effective decision is promoted since the responsible managers know the condition better
- It encourage the managers and individuals to perform better
- Manager is provided with freedom on making decision
- There is more time for the top managers to make decision policy and focus in long term strategic planning
- The responsible managers can make prompt response to the situation change
- Time saving on reporting to the upper management for decision making
Disadvantages:
- There will be competition and comparison among the managers of different segments and hence destroy the teamwork and co-operation in the management
- Decision make by the manager may be based on self interest but not on the favour of the whole system or department
- Interruption of power between the managers, repeating of the job may occurs
- Overused of the power in unrelated activities
- Difficulty in negotiation of price especially for the transfer price between the departments
(Figure 1 shows the types of responsibility centers and its elements)
3.2 Question 2 (b)
b) Explain ways in which the provision of more information need not lead to more effective management of a cost-centre.
There is a limit to the amount of information people can understand at any given time. Information overload is a common problem for new employees during the first few days, because they are often presented with too much information to comprehend in a short period of time. With the widespread use of computers and with so many emails and information available, new managers often do not know what to do with it all.
A budget centre is a section of the organization so designated for budgetary purposes. It may be a cost centre, a group of cost centers or a department. It will be the responsibility of a designated person, the budget person.
There are few disadvantages for a manager in cost centre of having information overload. First, there will be overemphasizing decision making. Cost centre managers may receive much information regarding the cost accounting transactions, such as both direct and indirect labour cost, material cost, administrative cost and etc from different departments in the company to make budgets for the company. Thus, too much information received from these departments may cause the cost centre managers to exaggerate in their decision making. One example for this point, clearly focus of those of managers interested in computerized decision support is on decision and decision making. Cost centre managers that apply Decision Support System (DSS) at their cost department may reinforce the rational perspective and over emphasize decision processes and decision making.
Second, the cost centre managers may have constant monitoring issues. A constant monitoring is necessary to ensure its effectiveness. Information overload may also cause managers unable to direct the cost and decision making activities with the requisite flexibility. Besides, if budgets are not allocated uniformly or as per immediate requirements, key functionalities might get affected and benefits might not be realized consistently.
Additionally, the cost centre managers might get forced to be fed with junk information when people produces more information than necessary for normal functioning, with most information of low quality. With these types of low quality information, managers will not be able to make an accurate budget account and decision for the company. Such distorted information may lead danger exist for misguided decisions on product pricing, product sourcing, product mix, and responses to rival products. Many companies seem be falling victim to the danger.
Furthermore, due to the uncertainty attached to the level of attainment and many of the other factors in budget preparation attempts have been made to recognize these inherent variability by the use of subjective probabilities and elementary probability and statistical theory in budget preparation. Therefore, when the managers are
‘surrounded’ with information overloaded and uncertainty, they may not be objective enough to make appropriate decisions, in which may cause the company to overspend their company’s money in some risk investments.
Moreover, it is a time consuming process which can generate volumes of paper work especially for the decision packages. Last but not least, there are also considerable problems in ranking packages and there are inevitably many subjective judgments. Political pressures within organizations also contribute to the problem of ranking different types of activity, especially where there are qualitative rather than qualitative benefits.
4.0 Question 6:
Discuss the impact of inflation and taxation on an investment appraisal. Use appropriate examples to support your answer.
4.1 Impact of Inflation on an investment appraisal
An investment appraisal is selecting investments where benefits of the investment outweigh the costs. In addition to that, cash generated by the project more than outweighs the lost opportunity to invest in other projects Impact of Inflation on an investment appraisal. An investor should consider both inflation and taxation effects on their capital budgeting decision.
Inflation can be defined as the decline in the general purchasing power of the monetary unit. For instance, if the inflation rate is 3% annually, then in theory a RM1 pack of sweets will cost RM1.03 in a year. After inflation, your ringgit cannot buy the same goods it could be forehand. In recent years, most developed countries have tried to maintain an inflation rate of 2-3%. In countries such as Argentina and Brazil, triple-digit annual inflation rates which is, average prices more than doubling each year have been an usual thing and have drastically affected investment decisions. If significant inflation is expected over a project life, it should be specifically and regularly examined in a capital-budgeting model.
One significant key to appropriate consideration of inflation in investment appraisal is consistent treatment of the minimum desired rate of return and the predicted cash inflows and outflows. Such consistency can be reached by counting an element in for inflation in both minimum desired rates of return and in the cash flow predictions.
There is always a tendency to assume erroneously that, when, both net revenues and the project cost rise proportionately, that inflation would not have much impact. These lines of arguments seem to be convincing, and it is correct for two reasons, which are as follows: first, the rate that is used for discounting cash flows is generally expressed in nominal terms. Many companies base their minimum desired rate of return on market interest rates which also known as nominal rates that comprise the inflation element. For instance, consider three possible components of a 12% nominal rate:
Three percentage shows out of the 12% return compensate an investor for receiving future payments in inflated ringgit, which is, in ringgit with less purchasing power than those invested. Thus, firms that base their minimum desired rate of return on quoted market rates will automatically include an inflation element in the rate. It would be inconsistent and inappropriate to apply nominal rate to discount cash flows which are not adjusted for the impact of inflation. Second, selling prices and costs show different degrees of responsiveness to inflation.
Firms that base their minimum desired rate of return on nominal rates should also adjust their cash flow predictions for expected inflation. For example, suppose 1,500 units of a product are expected to be sold in each of the next 3 years. Assume the price for current year is RM40, and inflation causes the price in next year to be RM42. The predicted cash inflow for the current year is 1,500 × RM40 = RM60, 000 and next year’s adjusted cash inflow is 1,500 × RM42 = RM63, 000. Inflation adjusted cash inflows are the inflows and outflows expected after adjusting prices to reflect anticipated inflation.
Let’s take a look in another example: acquire cost of equipment, RM 200,000 with the useful life of 5 years; zero terminal salvage value; pre-tax operating cash savings per year of RM83, 333; income tax rate, 40%. For straightforwardness, let’s us assume that the ordinary straight line depreciation of RM200, 000 ÷ 5 = RM40, 000 per year. The after tax minimum desired rate, based on quoted market rates, is 25%. It includes an inflation factor of 10%.
The Appendix 1 displays correct and incorrect ways to analyze the inflation’s effects. The key words are internal consistency. The correct analysis firstly uses a minimum desired rate that counts an element in which attributable to inflation and secondly clearly adjusts the predicted operating cash flows for the inflation’s effects. In addition, the correct analysis prefers the purchase of the equipment, but the incorrect analysis does not.
The incorrect analysis in Appendix 1 is intrinsically inconsistent. The predicted cash inflows exclude the adjustments for inflation. As a substitute, they are stated in 19X0 ringgit. Nevertheless, the discount rate includes an element that attributes to inflation. Such an analytical flaw could tempt an unwise refusal to buy.
Thus, the finance manager needs to be consistent in dealing inflation as the discount rate is market determined. In addition to this, the output price of a company should be more than the expected inflation rate. If not there is every possibility is to forgone the good investment proposal, because of low profitability. Furthermore, future is always unexpected of what will be the real inflation rate. Therefore, during the estimation of cash flows, along with output price, expected inflation must be taken into consideration. In treating with the expected inflation in capital budgeting analysis, the finance manager has to be very careful to correct analysis. A mismatch can cause significant errors in the investment decision making. Hence, the finance manager should always remember to match the cash flow and discount rate.
4.2 Impact of Taxation on an investment appraisal
Taxation has an important role to play in investment appraisal as it can have a substantial effect on the desirability effect or otherwise of the investment opportunity. In the appraisal of an investment project, what are important is the cash flows that will be generated by the project and that are available for shareholders. Therefore as far as investment appraisal is concerned, we need to evaluate the after tax cash-flows. We need to evaluate the project using after-tax cash flows and after-tax discount rates, this is either done through weighted average (WACC) method, ignoring interest payments and calculating taxes as if the project is all-equity financed, or else using the cost equity and including in the cash flows.
Taxation may complicates and arise impact on the capital investment appraisal in several ways. These are itemizing below:
The appropriate discount rate has to be chosen in order to calculate the present value of cash flow. Theoretically, where there is a perfect capital market, such as access to unlimited funds and all other worthwhile investments have been undertaken, the discount rate to be used should be the perfect capital market interest rate –the rate at which the demand for fund exactly equals the supply of funds (Fisher). Where the individual pays income tax then the discount rate must be adjusted to allow for this. This is because interest paid on the borrowed money by a business attracts relief from income tax, thereby reducing its cost to the borrower. Earnings from other investments are subject to income tax thereby reducing the opportunity cost of these funds. Even in the absence of perfect capital market, for example, where lending and borrowing rates differ, the principle of using the post-tax cost of borrowing as the opportunity cost of capital still applies (Hirshleifer).
Next, the additional profit (or loss) generated by the project in each year is subject to income tax payments or reliefs. The effect of tax on cash flow stream will reduce the size of the benefits if it is positive and to reduce the level of costs if it is negative. Furthermore, depreciation or known as fiscal allowance are given on certain types of capital investment, for example, machinery and equipment, which may be depreciated using the reducing balance method and buildings and works may be depreciated by using the tax depreciation method of constant annual allowances. These allowances will reduce the post-tax cost of the capital investment, which the size of the reduction depending on the marginal tax rates lead to greater reduction as do higher depreciation rates.
Then, where fiscal allowances (depreciation) are granted on the cost of a capital investment, they are not necessarily related to the economic depreciation of the investment. This is because governments use fiscal allowance to manipulate investments in the private sector. Investment is encouraged by granting tax reliefs in advance of economic depreciation, for example the accelerated depreciation, the greater the acceleration, the greater the investment incentive. This incentive is compounded by higher marginal tax rate. The acceleration of allowances may apply to all types’ capital investment or only to some depending on the government priorities.
However, some capital assets do not qualify for tax relief, particularly non-depreciating assets such as land. Thus, the tax system should not at first sight effect the cost if the assets. Although, non depreciating assets will often increase in money value in a period of inflation, the gain may be subjected to taxation even if it is only a nominal gain. Taxation on nominal gain will act as a disincentive to investment in this type of assets whereas failure to tax real gains will encourage investment.
A progressive tax system has more than one rate of income tax. Each successive slice of income is subject to a higher rate of tax. Frequently, these marginal tax rates are relatively narrow. This can make it difficult to predict the exact tax payments and reliefs that will accrues to a project as the benefits may shift the operating income to a higher tax chargeable.
The final problem is that tax reliefs and payments do not occur at the same time or period as the costs and returns that generate them. Generally, they are lagged and delayed by years from the point at which they are incurred. This reduces the present value of both tax reliefs and payments. This not only affects the cash flows, but will also affect the opportunity cost of capital and therefore the discount rates.
In conclusion, as has been demonstrated the incorporation of tax complicates investment analysis. The difficulties are increased because of the large number of different depreciation schedules that are used. Each schedule generates a different present value of tax relief invested. Consequently some capital investments have a lower post-tax cost than others. This has implications for investment decisions. Taxation brings more shortages than advantages in the evaluation of capital investment appraisal.
5.0 Conclusion
5.1 Question 2
Responsibility accounting is a management organizes system for measurement of division presentation of an organization. Responsibility accounting meeting points on responsibility centers such as cost centre, profit centre and investment centre. For efficient accomplishment of answerable accounting confident morality must be followed. Responsibility accounting helps not only in control but in planning and decision making too.
In conclusion it can be stated that the responsibility accounting is relevant to divisional performance measurement. Of the three types of responsibility centers, an investment centre type of responsibility centre which is only an extension of a profit centre can be considered to yield better results. Among the various approaches of performance measurement in investment centre analysis, residual income is evidently superior, though ROI is more popularly used in business circles.
5.2 Question 6
Inflation causes considerable problems in investment appraisal and should be incorporated in both the general and specific financial analysis of a project. It is accepted that inflation can be dealt with either by inflating the cash flows in line with the expected rate of inflation and discounting at the nominal interest rate, or by calculating the cash flows in present day dollars and discounting at the real rate of interest. Both methods will reveal an identical net present value for the same project, but in the internal rate of return will be expressed in nominal terms, while in the latter case it will be expressed in real terms.
The inclusion of taxation and finance under inflationary conditions leads to problems with the appraisal .The tax reliefs granted on capital investments via depreciation are generally not received immediately up to the expenditure but are spread over a number of years. This delay not only reduces their present value, as explained earlier, but also expenses them to the effects of inflation.
When it is remembered that the effect of inflation is to reduce the purchasing power of a dollar then it can be seen that delaying the receipt of the tax reliefs will not only reduce their present value, but will also lead to a reduction in the bundle of goods that can be bought with the tax relief received in any given year. The further into the future the relief is received, the smaller the bundle of goods that may be bought with the relief in that year because of the increase in the nominal or money price of the goods due to inflation. Thus inflation directly reduces the present value of the tax reliefs on capital investment.
References
6.1 Question 2
Websites:
1. James R.Martinm (2007), “Responsibility Accounting: Summary Exhibits”. [Online] Available from <> [17 November 2011]
2. Rehana Fowzia (2011), “Use of Responsibility Accounting and Measure the Satisfaction Levels of Service Organizations in Bangladesh”. [Online] Available from <> [17 November 2011]
3. Bezrouko, N. (c.2011) Information Overload [online] available from < > [19 November 2011]
4. Dutta, P. (n.d.) Advanatages and Disadvantages of Information Management Systems[online] available from <http://www.ehow.com/about_5494879_advantages-disadvantages-information-management-systems.htm> [20 November 2011]
5. Power, D. J. (2007) What are the advantages and disadvantages of computerized decision support? [online] available from < > [18 November 2011]
Books:
7. Lucey, T. (2003) 5th edn. Management Accounting: Budgeting. British Library
8. Johnson, T. H., Kaplan, R. S. (1987) Relevance Lost: The Rise and Fall of Management Accounting. President and Fellows of Harvard College
6.2 Question 6
Websites:
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Investopedia (n.d.) Inflation: What is inflation? [online] available from <> [20 November 2011]
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Kannadhasan, M. (n.d.) Effects of Inflation on Capital Budgeting Decisions – An Analytical Study [online] available from <> [20 November 2011]
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NGFL Wales. (2008), “Investment Appraisal” [online] available from <> [20 November 2011]
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Hirshleifer. (2004) , “A holistic view on investment appraisal” Available from
<> [16 Nov 2011]
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Thompson.J. (2007) , “ Session 6 Techniques of capital investment Appraisal ” Available from <> [16 Nov 2011]
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Philip E Dunn. (2006) , “Taxation and The Capital Investment Decision” Available from <> [ 17 Nov 2011]
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N.J. Williams. (2005), “THE TREATMENT OF TAXATION IN CAPITAL INVESTMENT APPRAISAL” Available from <> [17 Nov 2011]
7.0 Appendices
Figure 1: The types of responsibility centers and its elements
(source from http://maaw.info/ResponACCSum.htm)
